Overstock CC Notes

Here are my notes to the Overstock (OSTK) conference call I think is still undervalued, and this great quarter porves they are turning around. Any notes are in italics

• Revenue 201 mln up 27%

• Fullfillment partner growth 33%

• 17.3% gross margins

• Gross profits up 37%

• Marketing expenses up 33%

• Technology and SG&A down 6%

• Operating expenses down 9%

• Expenses up 6% w/o restructuring Though a lot of this is D&A, and CapEx has been falling

• Repurchased 5% of outstanding shares at $10.81 per shares Great return on those already, may have bought on the same day I did ;-)

• 3rd consecutive quarter of positive EBITDA, $3.5 mln vs. -$8.3 mln last year which is an OK measure b/c D&A is artificially high

• On ttm basis OCF became positive, $27 mln vs -$12 mln

• $90 mln in cash and marketable securities

• SEC said break-down revenue more and estimate on expected arrival date

• NO OTHER ISSUES surprisingly, and SEC approved their partner revenue accounting

• CapEx will be falling off, D&A will go away for most part

• Wish they had purchased more shares

• Brisk revenue growth acceleration He likes the word brisk now appearently, said it twice

• “We told you it would turn around by contribution, then gross profit then by revenue… gross profit growth at 37%, contribution at 41%, that’s what we want to see.” I like how none of the journalists who said they were crap have argued against this, proof Byrne is not crazy!

• Operating expense grew faster than revenue growth, then it got under after exiting the ‘inferno’

• In Q4 2006 cc said, “Contribution is going to be close to 10%. It is going to be far better than it has been.” It’s now at 9.8%, in a quarter with super bowl commercials

• All about generating contribution dollars

• Contribution dollar growth comes on essentially same revenue, just doubled efficiency on marketing

• Had built expense structure for $2 bln company, needed to get to a $800 mln company, %down from 30% to 19.5%, a lot is still D&A and this will be dropping a lot

• Probably $10 mln in CapEx this year

• D&A dropped about $8 mln this year may make them GAAP profitable

• Said, “We’re spending a lot of time to become more profitable. And we are willing to make some trade-offs between lower growth and higher profitability.” Now EBITDA has gone from -$15 mln to $3.5 mln in two years, This is what happens when you focus on an already good business, that 'any idiot can run.'

• Done what they said they would do, restructured the business

• Gone from OCF of -$40 mln+ to $27 mln now, in two years

• Inventory turns to 27x up from >10, maybe 30x is normalized. 6.8x on direct basis, turning inventory twice as fast as used to, can grow that business without growing inventory, so w/o more capital this means even though direct business (which is selling inventory from warehouse) doesn't have high returns relative to the partner business they can still get higher returns than they had because of this vast improvement

• Huge inventory liquidation, comfortable with amount of inventory now

• GMROI 695% ttm Investopedia says this is: "An inventory profitability evaluation ratio that analyzes a firm's ability to turn inventory into cash above the cost of the inventory. It is calculated by dividing the gross margin by the average inventory cost and is used often in the retail industry."

• 2005 AMEX customer service not in top 200

• 2006 number 4

• 2007 number 4, now above Nordstrom

• Net Promoter Score at all time high at 73%, even people who contact customer service at 28%, three times average company this is from The Ultimate Question: Driving Good Profits and True Growth

• Launched Overstock Cars I think this has potential to become a big grower

• Auctions adding tailwinds in earnings, expect more in next six months

• International expect to launch in June or July Also huge potential

• Community tab

• New tab this quarter

• Prime Broker suit, in second round of discovery

• Rocker & Gradiant, has progress, Judge lifted discovery stay, will begin trading documents

• Think Rocker’s libel suit is bogus and they will not win

• In a good place with litigation

• Bear Sterns may have been brought down by illegal naked short selling

Quick Update

A combination of immense studying and staying after school with my laptop screwing up for the second time in as many months has stopped me from posting at all in the past week, and will slow the amount of posts for the time being.

I will try to start posting regularly again as soon as possible, but may only post a few times in the next few weeks, but look forward to some long posts.

-Mike

Right Price Checklist: Conclusion

· Business, and an Explanation of the Checklist
· Moat
· Management
· Financials
· Valuation

The final part of the series, I've decided to put off the psychology post until I have time to learn more and know what I'm talking about, is the conclusion.

I believe there are three crucial factors to apply in your conclusion:

• Margin of Safety
• Why it undervalued
• Catalyst

Conclusion

Margin of Safety

Margin of Safety is at the top of any value investing strategy.

It's a very easy to understand concept: when buying shares in a company make sure they are worth more than you are paying.

The thing most debatable about margin of safety is how much of is needed. To guarantee future profits I like to look for companies that poseses a 40% margin of safety between the current price and value, but for truly great companies I'd pay up to 80%, with the intention of holding them for a very long time.

Why is it Undervalued?

This question is usually found in the investigation of the company, but it needs to be restated in words, so an analyst can easily find how it will be changed.

This can be as simple as a company missing earnings or as extremely strange as a CEO reporting that Gross Margin will be down, even if that is extremely obvious and not something that one should worry about.

Catalyst

Many value investors choose to ignore this. I think it is one of the most important parts of investing, and making sure you haven't found a value trap.

These are usually easy to find, what will make the stock price reach the company's value? this can be as easy as continuing earnings growth, or more complex like a competitor raising its prices.

Buy or Sell

The last decision is when an analyst sums up all his research and decides whether to buy or sell.

To run a truly concentrated portfolio, I would suggest not buying a company unless the business is great and can be proved so by the financials, the management can run the business and allocate capital without the need of debt and there is a high margin of safety between the stock price and value.

Also, I advise holding 15 or less stocks, and even if a company passes all the above tests if it doesn't possess a good catalyst to propel the stock price in the coming years, I would pass on it.

Blockbuster

Margin of Safety

For this I will use two values, the value form Pabrai's multiple and Matt Richey's DCF.

The value form Pabrai's multiple was: $50.58 this is a margin of safety of just 13%.

The lower case scenario gave a value of $64.75, and the middle case gave $90.69, though it was $72 with a 12% discount rate. This present margins of safety of: 32%, 52% and 39%.

I'd say the range of values is from $50.58 to $72, so the margin of safety is from 13% - 39%, because best Buy dominates its industry and continues to repurchase shares I think this is sufficient.

Why it's undervalued

Best Buy reached a high of $52.29 in December, after that some funds sold their stake and in February it reduced guidance for this year and fell to $39.87, since then it's creeped up a little to $43.83 where it stands now.

Catalyst

I believe Best Buy has a few catalysts:

• Future earnings growth propelled by battles between HD and Blu-Ray and its continued market share gains as Circuit City falls off the planet or is bought by Blockbuster
• Share repurchases

Buy or Sell

This is a hard one for me, I will continue to examine AXP and some special situations at which I'm looking, and decide whether Best Buy has better potential than these, but for investors looking to find a good undervalued company I believe Best Buy is worthy.

The author owns no shares of Best Buy, this article, in no way, is a recommendation to buy or sell any securities.

Joe Koster Interview, Part Deux

In January of 2007 I posted an interview with Joe Koster, an analyst for the firm where I had interned over the summer.

Since then Chanticleer earned 68% net to investors in 2007, by mining for micro-cap value stocks and doing intensive research and scuttlebutt, and the stock Joe mentioned in the first interview,Tandy Leather, is down over 65%.

Right Price Investing: In the last interview you talked about Tandy as one of the companies in your portfolio, and valued it in the $8.50-9 range, a lot has happened since then and it's currently trading below $3 per share, where do you value it now?

Joe Koster: We think the value is north of $6 for sure.

We think it will still be worth $8-10 once they get back to a more normal environment, although the time frame for getting there may be pushed back a bit. At the time of our first interview TLF was at about $7.80 per share, so I mentioned the margin of safety wasn't really there.

We got interested again when we though it was a fifty cent dollar, about $4.25-$4.50. It is now trading for book value which we think is solid, will still make a few million dollars in a tough environment, and you get a free option on the 51% of mineral rights they are entitled to on the land they own but don't use for operations. Management is great and the current price certainly looks attractive

RPI: So in short what has happened to Tandy's business to cause it to be abnormal right now, and how soon will they fix it?

JK: It really has just slowed down, like many other retail/consumer related businesses. They had put some infrastructure in place for growth and when growth slowed, the infrastructure ate into the profits a bit.

In 1996-1998, sales were down 10%, 10%, and 13% in those three years. Operating income for those years was $(305,700), $1,189,067, and $845,625 on sales of about $28mm, $25mm, and $22mm.

So although I can't give you a good estimate as to when sales will pick back up, I can say that I am pretty confident they'll continue to make money, grow intrinsic value by some amount, and that by buying around book value, I consider to a Mohnish Pabrai type of investment -- heads I win, tails I don't lose much.

RPI: You interviewed Pete Bevelin, author of Seeking Wisdom, and link to a lot of articles about mental models on your site, how would you recommend an individual investor learn to use mental models and then apply them?

JK: I am of course still early in the process myself, but I've found that it is amazing how they find their way into daily life once you've learned some of them.

For example, I think about Robert Cialdini's models in his book Influence all the time. After interviewing Mr. Bevelin, I read Charles Darwin's autobiography and got a vivid picture of a model that is useful for analysts.

Charles Darwin went through great effort to collect facts (through direct observation) and look for disconfirming evidence before he published a theory. He spent 20 years collecting facts before he published his thoughts in what became his most famous work, Origin of Species.
That model of intense fact finding before the theory is basically just the scientific method, but it became very vivid when I read Darwin's autobiography.

My recommendation would be for those new to the mental model/latticework/Munger process would be to read Poor Charlie's Almanack and let that take you to the next destination.
Different people may be more curious about certain disciplines and choose to start that process in different places, but as Mr. Munger and Mr. Bevelin have mentioned, psychology is very important. As for ways to apply mental models, if Charlie says checklists are the best way, that is probably the way to go.

RPI: As mentioned in the last interview Chanticleer does a lot of scuttlebutt before investing, do you believe this is possible for individual investors, if not what is the main thing you look at to gauge management’s integrity?

JK: I read somewhere that Seth Klarman once had (or maybe still has) a race horse named Read the Footnotes. I think the name of that horse is really great advice for individual investors, since very few actually do read the footnotes.

Most of the scuttlebutt we do is on the small companies we're looking at and although we find it useful, we know that we also have to be careful because company management usually has a rosy picture of where their company is heading and you don't want to let that attitude influence your objectivity. It is not a bad thing that they have that attitude, it is just important to be aware of it.

For individual investors who don't talk with management or do other scuttlebutt, I think they can get great insight by following the paper trail: What is the management team's track record? What have they done with the cash? Do they do what they say they're going to do? Are their interests aligned with shareholders? I think the answers to questions like these can go a long way in determining integrity.....and then buy with a big margin of safety just in case!

RPI: You have amassed a huge store on Amazon, are there a few less well-known books you would recommend to readers?

JK: Sure:
· Seeking Wisdom: From Darwin to Munger, 3rd Edition by the previously mentioned Peter Bevelin is really great.
· Competition Demystified : A Radically Simplified Approach to Business Strategy by Bruce Greenwald is one of the best $5.49 values you can find, in my opinion.
· The Long Tail: Why the Future of Business is Selling Less of More by Chris Anderson was really great,
· As was Fortune's Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street by William Poundstone.
· It is probably on the best seller list, but I highly recommend Isaacson's biography on Einstein.
· I just bought Speculative Contagion: An Antidote for Speculative Epidemics by Frank Martin and although I'm saving it for the plane trip to Omaha, I have read his last couple of annual letters and I think that it is going to be a great read.

For more from Joe, check out his blog and Chanticleer's site.

Right Price Checklist: Value

· Business, and an Explanation of the Checklist
· Moat
· Management
· Financials

Valuing a business is how a successful investor can decide when to buy and when to sell great companies.

Before I start, I'd like to add that when doing my analysis I like to keep any valuation out of my head until the end, to keep myself from becoming biased, I don't even look at the stock price.

In this article the methods of valuations I will use are:

• Target Price
• Pabrai Multiple
• Pabrai DCF
• Matt Richey's DCF
• Absolute P/E
• Croesus Test
• Reverse DCF
• Liquidation Value

Valuation

Target Price

The first test is relatively simple, but not one that should be used without taking a spoonful or so of salt.

To find a target price, one projects revenue five years into the future, then converts that into income with a projected net margin, then after projecting the amount of shares five years out convert the income into EPS and finally apply a multiple where the business would likely trade.

This method shouldn't be used for valuation, but it helps to show how much the share price can rise with the expected growth and margin expansion.

Pabrai Multiple

In an interview Mohnish Pabrai said a business with no growth, but consistent cash flows, should be valued at 10x cash flow plus excess capital, conversely a growing business should be valued at 12-15x cash flow plus excess capital.

This is the formula for excess capital: Excess Capital = Book Value – Fixed Assets – Goodwill – Working Capital Needed for Operations (2% of Sales)

Pabrai DCF

In his first book Pabrai spends a chapter detailing how to use a DCF.

His use is a little off the usual, but it works. He recommends predicting ten years of cash flow, discounting it back to the future and then assuming the business would be sold for the excess capital at the end of the tenth year.

Matt Richey's DCF

Matt Richey is one of the mutual fund managers for whom I have the most respect. When he wrote for The Motley Fool he wrote an article on DCFs and was kind enough to send me his spreadsheet. The sheet allows for three different expected growth rates to find the best worse and most likely cases.

Absolute PE

This method is the newest one to me. It is found in Active Value Investing by Vitaliy Katsenelson.

The model uses a chart to determine a basic P/E using expected growth and dividend yield, and then applies the basic P/E to this formula:

• Basic P/E x[1+(1 - Business Risk)]x[1+(1 - Financial Risk)]x[1+(1 - Earnings Visibility)]

The book shows the chart to use for basic P/E and how to determine the different risks, I encourage anyone who hasn't already to buy the book.

Croesus Test

The Croesus test is one of my favorite methods. It's comparable to the target price, but instead of entering earnings growth one enters in the dividend yield and the return they want over a certain number of years, and the P/E at the end, and the method tells them what earnings CAGR is needed to produce this return.

For more information on the math involved, I first read about this method in It's Earnings That Count.

Reverse DCF

In a DCF an analyst applies his expected growth rate to cash flow and then adds up the cash flows after discounting them back to the present. This tells the analyst what the value of the company is.

In a reverse DCF the current market value is inputted and the method shows what earnings growth is needed to support the current market value, this does not give a specific market value, but does give a general view on whether or not the stock is undervalued.

Liquidation Value

I first read about this in Seth Klarman's book (I won't link to it because it's like $3,000 or something), he uses it to find what the bottom for a stock is potentially.

Though a company may have a certain liquidation value that does not mean the stock will never trade below that value (Sears Holding currently trades below liquidation value), just that an investor should not have long-term losses below it.

In liquidation value an investor should assume the full value for liabilities and for assets the following percent should be realized:

Asset               Percent%

Cash                    100%
Marketable Securities   100%
Accounts Receivables     85%
Inventories              50%
PP&E                     45%
Goodwill                  0%
Deferred taxes            0%

I'd like to add to this that if a company owns its own real estate this should be taken 100% and if the market has gone up a conservative appreciation should be added.

Best Buy

In the Best Buy valuation I will use a 5% margin on Revenue, the FCFF of $1.7 billion, growth over the next five years of 12%, growth in years 6-10 of 8% and growth from years 11-20 of 5%, terminal growth of 2.5% and a discount rate of 10%.

Target Price

At 12% growth in five years revenue will be about $69.6 billion, 5% of that is about $3.5 billion, then assuming no share dilution (and to be conservative no shares repurchased).

At a 17x multiple this gives a share price of $122.27, which is 186% growth in five years from the current price.

Pabrai Multiple

Applying a 15x multiple to Best Buy's current EPS of $3.19 give a value of $47.85 per share, it has negative excess capital because of its high accounts payable so I will just add the cash per share which is $2.73 this gives a value of $50.58

Pabrai DCF

Using the expected growth and not adding excess capital Best Buy has a value of $69.76 per share.

Matt Richey's DCF

Using 3% more for the growth in the best case and 3% less for the low case, I get values of $130.26, $90.69 and $64.75.

This gives very high values, if the discount rate is changed to 12% the median case drops almost $18 per share, and as shown 3% less per year growth makes it drop $26 per share.

Absolute P/E

16.4 x [1+(1 - .95)] x [1 + (1 - .95)] x [1+ ( 1- 1.05)] = 17.18

$3.19 * 17.18 = $54.86

Croesus Test

These three inputs all assume and ending P/E of 15x, and using the net income of 1.4 billion.

To get a 25% CAGR over two years Best Buy would need earnings CAGR of 22.7% over the same period.

For 17% over five years, 16%.

For 15% over the next ten years, 14.5%.

Reverse DCF

Using Quicken if Best Buy grows 6% terminally and using a 15% discount rate (the 6% can't be changed and 15% discount rate is used to offset it) Best Buy needs to grow 4.7% annually over the next ten years.

Liquidation Value

Asset                    Value         Adjusted Value (in millions)
Cash                    $1,319         $1,319
Marketable Securities   $  295         $  295
Accounts Receivables    $  739         $  628
Inventory               $7,451         $3,276
PP&E                    $3,260         $1,467
Goodwill                $1,182         $    0
SUM                                    $6,985

Portfolio April 08

Last Time

The last post was on the 19th, but I've decided to take a quick break from the checklist, the valuation post has a ton of methods, and update the portfolio now, after some recent sells.

The current total amount of the portfolio is $9,069, subtracting $500 in cash I added and it's at $8,569 which is an 8% gain, representing a very strange up month, and here we'll find out why.

Positions

American Express (AXP) $967.72 11%

AXP is currently trading for $43.76, which is up 4% from $42 where it was on March 19th. It currently represents 11% of the portfolio, which is down a percent since the last post mainly because the portfolio as a whole is up higher than it is.

Since the last post American Express bought GE's money unit, but there hasn't been any other real news.

I currently believe American Express probably has too much allocation as opposed to its gain potential and would consider selling part of it if it goes up to around $50-5 to raise money for other positions with better potential.

Assorted Special Situations $1126 12%

These positions have moved around the most, I currently hold three special situations, but only one is the same from the last post.

I will continues to try to find good special situations and have raised a bunch of cash to invest in them.

K-Swiss (KSWS) $780.5 9%

K-Swiss traded at $14.65 in the last post, since it currently trades at $16.26 it is up 11% since the last post. It has 9% allocation, which is the same it had last month.

No news on K-Swiss, but I did write about it and have renewed confidence in its potential, and may invest more into it, depending on how Best Buy turns out.

Netflix (NFLX) $528.5 6%

I sold half of the positions as it neared an all-time high, but held the other half because I still like its long-term prospects and believe it offers a better return than cash, or any other opportunities I've found. It's up 14% in the last month.

I wrote about Netflix twice since the last post.

Overstock (OSTK) $1,258 14%

Overstock is up an amazing 47% since the last post (and up about 40% since my last average down). It now makes up 14% of the portfolio, up from 11% in March. I am now down only 2% from my average purchase price.

Overstock is up on no news, except for maybe my article, and I still see it as extensively undervalued.

Sears Holding (SHLD) $1,631 18%

SHLD is up about 7% in the last month, its allocations has fallen 2% because of the added cash and the portfolio rising as a whole.

Sears did a bunch of stuff in the last month including buying the footstar rights for its stores, which will save them a crapload of money, and will offer 10% bonuses to people who convert their stimulus check into K-Mart gift cards (I actually think my parents did this like 7 years ago with Target and I ended up getting a PS2 out of it so this is probably a good sign), but not a whole lot of news that would shock anyone.

Tandy Leather (TLF) $599.50 6.6%

Tandy is up 3% in the last month on no real news (it said sales will be down but nothing really happened).

I'll be interviewing Joe Koster again soon, and we'll talk about Tandy in that post.

Western Sizzlin' (WSZL) $1,372.55 15%

Western Sizzlin' is the lone stock to fall in the last month falling 4% after it suceded in getting on SNS's board, got turned-down by Itex shareholders, got controlling interest a fund that gives it $55 million more to invest, and it filed its 10k (at which I have yet to look).

I believe Western Sizzlin' offers the best potential returns among all my current positions.

Sold Positions

Steve Madden (SHO)

I wrote about this here.

Sybase (SY)

Sybase was the other tender offer I held, we called the morning of the expiration date, but it expired on a Monday at 9 am (est), and Scottrade offices in Utah don't open until 11 (est) so go figure. They were gonna charge us $25 to tender the shares with no guarantee we'd even get the current price, so we sold our shares for a gain that pretty much covered the $14 commissions.

Penn National (PENN)

No negative news on this one, I just think I can find some better situations with more certainty.

Potential Buys

Steak & Shake (SNS)

This is the restaurant that Biglari is currently acting as an activist with, see this presentation for more info on its investment opportunity.

Marathon Acquisition

I don't know a whole lot about this, not really much of anything actually, but there is potential I believe and have printed about 50 pages of stuff on SPACs to read today.

Best Buy

I talked about this one last time as a potential addition and have been analyzing it with my Right Price Checklist series.

Right Price Checklist: Financials

· Business, and an explanation of the checklist
· Moat
· Management

Analyzing the financials of a business is necessary to find how cash runs through a business and measure how a company's assets compare to its debt.

In this article I'll go over what to analyze in each of the two main financial statements, and how to find cash flow.

Financials

Income Statement

Margins

High margins are one of the best ways to judge how efficient a company is. They also help show who has the better competitive advantage, either by a better cost system or the ability to price their goods higher.

I like to look a gross margins, operating margins (which are usually the best way to compare competitors so different tax rates don't skew the results), profit margins and cash flow margins.

Expenses

After looking at margins it is a necessity that one use a percentage analysis, this is done by dividing each expense by revenue to find where revenue is spent before it falls down to income.
It's also beneficial to find how expenses may change. Companies like Overstock have artificially low income numbers because their variable expenses can be leveraged in the future to allow more money to fall to the bottom line.

Growth

Growth fuels investor's returns. If a company can grow its earnings in double digits for multiple years it is likely to be undervalued.

I first like to focus on revenue growth, if a company will be growing income in the future based on more products sales, or if it grows income by reducing expenses anticipating revenue growth will allow you to find income growth.

Also, when evaluating past growth, if you expect growth to stay at its current level, make sure the growth rate is climbing.

Balance Sheet

Cash

I like to start with the assets and cash is the first thing I check.

First, check to make sure cash is growing, and also that it is a good percent of current assets.

Other Current Assets

As before mentioned check to make sure a company isn't growing its revenue on accounts receivables, if accounts receivables are growing faster than revenue you may want to pass.

A lot of inventory can be good or bad. If the company has a lot of finished goods inventory it can mean a drop in sales is near, but if the company has a lot works-in-progress inventory it can signal more revenue growth soon.

Watch for a lot of deferred tax assets, these only last so long.

Intangibles

These can also be positive or negative. Intangibles assets can provide a competitive advantage, but it should probably not be included in any valuation.

PP&E

PP&E is hard to judge and can be good if real estate was purchased a long-time ago, but equipment and other property can erode sometimes faster than management expects.

Debt

In general I frown upon long-term debt, but in some industries it is necessary, so it is best to look for companies with little debt relative to competitors in stead of not investing in companies with debt period.

Also, as Steve mentioned, a high accounts payable balance is not always a bad thing.

Many retailers can produce excess cash amounts by managing their working capital well and extending the amount of time they have to pay suppliers to a period longer than the time it takes them to collect from customers.

Cash Flow

There a innumerable amounts of ways to measure cash flow and almost every entry can be taken out or added into income to come up with a different amount, I will only go over four kinds here, but recommend reading non-stop to learn all the ways.

The four I will go over are:

• Free Cash Flow
• Owner's Earnings
• Free Cash Flow to the Firm
• Maintenance Vs Growth CapEx

Free Cash Flow

Free cash flow is simply Operating Cash Flow minus Capital Expenditures. This is good to use for quick comparisons to other company's valuations or to income, but I would not put much stock in it as companies can add a lot of crap to what determines operating cash.

Owner's Earnings

A more clean way to find cash flow, and Warren Buffett's method, is to add back non-cash charges like deprecation and then subtract the actual expense: capital expenditures.

This method helps more than free cash flow, but it does not take into account any changes in working capital. When a company increases accounts receivables its sales go up while it does not collect the cash, conversely they may account for expenses that they have yet to pay with accounts payables.

Free Cash Flow to the Firm

To account for these working capital changes you can use this method. It's the same as owner's earning, but the change in working capital is applied.

It is important to point out that when using net income to find real cash flow, you are using relatively unpredictable items, like interest, that are not related to the operations of the company. A way to correct this is to apply the tax rate to operating income and then add back non cash charges and subtract capex and investment in working capital.

Also, companies can't grow cash flow based totally on working capital changes forever so it is important to compare free cash flow to the firm with owner's earnings.

Maintenance Vs. Growth CapEx

Capital Expenditures is the cash paid out to invest in the company. It buys PP&E and other things to help the company sustain its growth.

Some companies have huge CapEx because they are trying to fund huge growth. Some analysts say that this high CapEx number punishes the company when its maintenance (what it would take to sustain the current earnings) CapEx would be lower.

They then advocate separating maintenance CapEx from growth CapEx to find the real cash flow.

Here's my position on this: If a company needs to spend money to grow, that's cash going out the door, regardless of whether or not its funding growth the company will not need in five or ten years.

So if you're going to separate the two to apply to numbers in the future more power to you, but if you separate them and then apply it to a multiple today I believe it is the inverse of what the initial goal was, to find the actual amount of cash a company made in the year. This is because even though a company could sustain its current operations with a lower CapEx number, it has chosen to grow in stead and pretending it didn't spend that money to grow is an easy way to get mediocre returns.

Best Buy

Income Statement

Margins

Best Buy's margins are among the best in the industry. While it has a five year-average of a 25% gross margin and 4% profit margin, Circuit City has averaged 24% gross margins and less than half a percent profit margins.

Growth

Best Buy has a good history of growth. Over the past nine years it has a steady history of 17% revenue growth and 30% (though a lot less steady) income growth.

The income growth is volatile, but I believe they can grow in double digits for at least a few more years.

Balance Sheet

Cash

Best Buy's cash makes up 10% of its assets and has grown an average of 16% per year over the last nine, 19% in the last year.

Other Assets

Best Buy has inventory of almost half of its assets, though this is fine since it is a retailer and this could signal good revenue growth soon.

Debt

Best Buy's long-term and short-term debt account for only 3/4's of its cash, so it is not over-leveraged.

It does have a lot of accounts payable, but this is fine.

Cash Flow

Free Cash Flow

Best Buy has Free Cash Flow of $1 billion which is about a 6% earnings yield.

Owner's Earnings

Best Buy's Owner's earnings are $1.25 billion which is a 7% earnings yield.

Free Cash Flow to the Firm

Best Buy's FCFF is $1.7 billion which is a 9.7% earnings yield.

The 84th Festival of Stocks

Welcome to the 84th Festival of Stocks. This blog carnival, started by Fat Pitch Financials, highlights the best stock-market related posts in the Blogosphere.

If you haven't been to this blog before, I am a 17 year-old investor, with almost five years of experience. I manage my own money and that of some relatives using value investing, portfolio concentrations and select special situations. For more please visit the About Page and the inaugural post in my ongoing Right Price Checklist Series.

Now on to the Carnival:

Article Submissions

Retirement

Silicon Valley Blogger presents Save and Invest Enough For Your Retirement: Are You On Track? posted at The Digerati Life.

Stock & Fund Analysis

James Cullen presents Don't Feel Guilty, Wal-Mart (WMT) Is Good posted at College Analysts.

Jorge H. presents General Electric Fizzles - Market Retest of Lows? posted at Investing Adventures.

Four Pillars presents New Vanguard Global Stock Index Fund and ETF posted at Quest For Four Pillars

Anthony Dadlani presents Will the iPhone eat Blackberry's (business) lunch ? posted at The Creating Wealth Blog.

Geoff presents How Much is Visa Worth? posted at Wealth Monkeys.

Mike Price presents Best Buy's Management Analysis posted at Value Investing, and a Few Cigar Butts.

Portfolio Update

George presents Special Situations Real Money Portfolio March 2008 Update: The lastest updates on Fat Pitch Financials' investments in tender offers, spinoffs and other special situations. posted at Fat Pitch Financials.

Investment Philosophy

Enoch Ko presents Maximize the power of compounding: Understand how to calculate the effect of compounding and how to maximize the power of compounding posted at The Wealth Accumulator

Tyler presents Dividend Growth Fund Strategies Revealed: An article that details how to select stocks that offer dividend growth posted at Dividend Money

MBB presents Avoid The Greatest Investing Pitfall - Don’t Trade On Emotion Or Gut Feelings Alone posted at Money Blue Book

Steve Faber presents - Beginner Stock Investing – How Can You Get Started? posted at Debt Free

Kacper Wrzesniewski presents Successful investing with Moving Averages: Investing with moving averages is very easy and effective. It is one of my favorite tools from technical analysis. posted at KacperWrzesniewski.com

Pinyo presents Ask The Expert with Larry Swedroe, April 2008 Issue posted at Moolanomy.

Steve Alexander presents Little Books, Big Profits posted at MagicDiligence - Optimizing Joel Greenblatts Value Stock Strategy.

Dividends4Life presents Measuring Asset Allocation Across Your Entire Portfolio: I recently undertook a significant project to measure my asset allocation over all my investment holdings using three different measures (origin, capitalization and sector). This is the process I followed. posted at Dividends4Life.

Rocko presents Polynomial Regression Edge Trading via Excel posted at The Mathematical Think-Tank.

G Blogger present What Buffett’s Been Doing Lately—And Does Kiplinger’s Have a Man Crush? posted at Can I get Rich on a Salary

Personal Finance

Barb A. Ryan presents 1 - Your Personal Financial Planning Skills posted at Pasadena Financial Planner.

MBB presents Best Online Discount Broker List posted at Money Blue Book-Personal Finance Blog

Right Price Checklist: Best Buy Management

Business, and an explanation of the checklist

Moat

Management

Integrity

Pay

Best Buy (BBY) CEO Robert Willert was paid $8.65 million last year, as opposed to $6.95 million by Circuit City (CC) CEO Philip Schoonover.

Best Buy's market cap is about 26x larger than Circuit City's, Willert's salary isn't even close to being double Schoonover's.

Restructuring

Best Buy has no one-time charges in the last three years.

Related-Party Stuff

Best Buy has multiple related party transactions:

• Two stores are leased from founder and chairman of the board Richard Shulze, the rents paid for these stores in 2007 were $976k. The company also leases airplanes from a corporation owned by Schulze, and paid him $393k for them.
• The company does business with Shulze's brother's business Phoenix Fixtures, and paid them $19 million last year.
• His daughter, Susan Hoff, received $505k for running The Best Buy Children's Foundation
• A director, Ari Bousbib, is president of Otis Elevator which received $230k for equipment in 2007.
• Director, Elliot Kaplan, is a partner in the law firm that serves as Best Buy's general counsel, they paid them $83.8 million in legal fees in 2007.
• Kaplan's daughter, Jane Kirshbaum, is their senior corporate counsel and received $200k in base salary and was rewarded 1,255 shares in options.
• Director, Matthew Paull, is a senior VP with McDonald's, with whom Best Buy has a co-marketing agreement and paid $3.1 million dollars for coupons and gift cards through the marketing agreement.
• Director, Frank Trestman, owns a third (his son also owns a third), of The Avalon Group, from whom Best Buy is leasing a property for the next ten years, at $700k for the next five years then $745k for years six through ten.

All this related-party stuff scares me about Best Buy's management, especially the fact that they claim, "It is our policy not to participate in related-party transactions... unless the transaction provides us with a demonstrable incremental benefit."

I'm not an expert, but I bet they could have found someone other than the founder's daughter to run their charity organization, and I'm pretty sure they wouldn't have to pay this person half a million.

Board of Directors

Best Buy has eleven members on their board, which is a lot considering since members include:

• The former chairman of Pepsi Bottling in Mexico
• The founder of a patient access and revenue cycle service company for health care providers
• A former CFO of McDonalds
• The executive chairman of a wireless Internet provider in California and
• A partner in the law firm that serves as their general counsel

I'm not sure they really need any of those five, and am starting to become suspicious of the company's management.

Pension Fund Stuff

There is no mention of the pension fund in the 10f or the proxy.

Revenue

Best Buy records revenue when,

The sales prise is fixed or determinable, collectibly is reasonably assured and the customer takes possession of the merchandise, or in the case of services, at the time the service is provided.

Sounds good, and I don't think Best Buy really has a business model where revenue recognition would ever come into questions.

Receivables are up 35% over the past year, and 97% since 2004, while sales are up 8% and 53% over the same periods. Again, this is a warning that Best Buy could potentially get itself into trouble.

Earnings

Best Buy missed analyst estimates by more than 20% in the May 07 quarter, so I don't think fudging earnings for this reason is a problem.

Total Net income over the past ten years is $5,936 million, over the same period they have free cash flow of $6,772 million this is a 14% differential, which over ten years is probably fine.

Ownership

I can't find Willert's direct holdings, but 18% of Best Buy is held by insiders, and considering this is a $17 billion company that's fine with me.

Auditing

Best Buy was audited by Deloitte & Touche, apparently a good company to work for, that I believe is fine here.

Competence

Expenses

Best Buy's only real direct competitor, Circuit City, has 2% higher COGS and 5% higher SG&A than Best Buy, so it looks like management is good at cutting costs.

Debt

Best Buy has $642 million in long-term debt, but over $1.3 billion in cash. It is troublesome that they have over $4 billion in accounts payable, however.

Returns

Best Buy's has a 26% return on equity, but just 11% return on assets which shows they use leverage to pump returns.

Retained Earnings Contrasted to Market Cap

Over the past ten years they have created $3 in market value for every dollar in retained earnings, which shows they are good at creating shareholder value.

Shareholder Communication

Earnings Reports

The report is called, Best Buy's Fourth-Quarter Earnings Per Diluted ShareRise 10% to $1.71, this is satisfactory, but at least they use gaap earnings instead of some pro forma crap (not that gaap isn't crap, its just generally accepted).

The What they say analysis will encompass a post on its own, and will come next.

Right Price Checklist: Management

My Internet connection was down on Monday and Tuesday, and for the rest of the week I had to go before and stay after school for some upcoming AP tests, which explains my hiatus. I'm happy to say I've improved in Calculus by about 25%, by putting in about 15 hours so far in extra studying, which is most likely a positive.

Luckily, Spring Break is the upcoming week, so I'll have a lot of time to finish the checklist and make my conclusion on Best Buy, then work on some projects.

Business, and an explanation of the checklist

Moat

Management

The next part of the series is management, some investors call this the most important of the analysis, it is the are where I have the least experience and have tripped up the most in the past.
I don't have any way of talking to management from any company, save the one for which my dad works, so my analysis will be only things that one can find on any computer.

I believe there are three distinct things to look for when evaluating management:

• Integrity
• Competence
• Good Communication with Shareholders

Integrity

Integrity is of the utmost necessity for good management. If a shareholder can't tell if the management of his company is telling the truth, there is no need to have anything to do with that company.

I use a number of different measures to gauge management's integrity, gleaned from different sources that will be mentioned later.

Pay

This is a big one in the news, but I don't find it as big a deal as people like to make it. Yeah, CEOs make a truckload of money and the Average Joe doesn't, but I doubt the Average Joe paid in the same amount for education or worked the same amount of hours to get to the position where an Average CEO is. I also doubt the Average Joe has to run a multi-billion dollar business, with the public watching his every move.

That said I have nothing against the Average Joe, and do believe management can be overpaid.

If I get to this point in my analysis its obvious management is not completely incompetent, and I believe they should make at least what the CEO of a competitor makes, maybe a little more because they run a good company, but if its a huge premium there's something wrong.

Also, a company should not need to issue a ton of options to motivate employees, a little is fine, but excess amounts just breed bad ethical decision making. I'll also monitor options granted (it should stay under 2.5% of income, at the most) as a percent of income and share growth.

Restructuring

This includes all one-time charges, restructuring charges, limitless write-downs, etc.

If a company has a one-time charge every year, it is no longer a 'one-time' charge (I think that's from Thornton O'Glove).

Related-Party Stuff

Companies have to report any related-party transactions. Some of these are fine, and don't need to be worried about.

But, if the company is loaning excess amounts of money to the chairman's son for his business you should probably steer clear, because management obviously doesn't care about the shareholders' best interest.

Board of Directors

Look at who is sitting on the board of directors, if there are more than ten members or if many of them are politicians, members of the founding family or others with no business background you should probably pass.

Also, if the Charmian of the board is also the CEO it is unlikely the board will ask him any challenging questions.

Pension Fund Stuff

Michelle Leder calls this the best way to easily find if a company reports trustworthy numbers.

There are too things to look for regarding pension funds are they overfunded or underfunded and the expected return rate.

In the pension fund footnote the company reports their pension fund obligations and assets. If the assets are more than the obligations, they have an overfunded account, if the assets are less it is underfunded.

Both can be troublesome, if the fund is overfunded it could be inflating earnings, so look hard at earnings to find if it is. If it is underfunded it creates a drag on net income (look at General Motors, who has had possibly the worst pension fund management in history).

Companies also report the rate at which they expect their pension fund to grow. If this rate is too high (Robert Olstein says 6% should be the highest rate, because it includes fixed income and stocks) it shows the company has too aggressive accounting and adds to the net income amount, without adding cash.

Revenue

This part of the analysis is two-pronged: recognition and receivables.

How companies recognize revenue says a lot about how they do business. If they sell a product they may record revenue when the contract is signed to sell the product, when it would be better to record it when the cash is received after they ship the product. Checking how a company reports its

Also, if revenue is growing fast, but when you check accounts receivables they are growing just as fast there might be future trouble if the company is unable to collect the money it is owed.

Earnings

This is a quick one, if a company never falters in its earnings and always meets the target it is probably fudging earnings (Genrral Electric did this a lot in the past).

Look at the past ten years of earnings, if there is never a drop in growth or if they always meet the target (you can find this on Yahoo Finance) be suspicious and look into how much of their earnings each year are actually cash.

Which is also part of this analysis, it is beneficial for an investor to compare the free cash flow (or owner's earning, or other cash flow measure) with the actual net income, if it varies (in either direction) by a lot the company is reporting income that it hasn't earned in actual cash.

Ownership

This is a very arguable criterion. A lot of people base their investment decisions on inside ownership, other claim it does not matter.

I believe a healthy amount of insider ownership aligns management's interest with that of the shareholders.

I also believe, that when management owns part of a huge company it is hard to own a big percent of the shares. So I look at the absolute amount of a company management owns. If the CEO owns $100 million worth of stock, but he runs a multi-billion dollar company, it won't show up as huge inside ownership, but he obviously has the shareholder's interest on his mind.

I also don't care much for insider buying or selling, no one knows the reasoning behind insider buys and sells, and in my mind it is a waste of time to try to figure them out.

Auditing

The last part of the integrity analysis is to check the auditing firm, if they are a no-name firm that doesn't seem likely to ask hard questions, one should view the financial statement with a grain of salt.

Competence

Expenses

I have a page in my spreadsheet that does a percent analysis for the income statement. It breaks down what percent of Revenue each expense accounts for.

If a company has lower margins than competition identifying the expense causing this is crucial to turn-around, if management seems ignorant of this, pass on the company.

Debt

It says in the Bible, "The rich rules over the poor, And the borrower becomes the lender's slave (Proverbs 22:7)."

Regardless, of one's religious beliefs it is obvious that one in debt will act differently than one funded strictly with cash.

The same goes for companies, if a company is focusing all its interest on how it will pay off its debt, it has no time left to figure out how to grow.

Look to see how debt a company has, and also find what percent it is paying on that debt in interest, if the interest payments alone account for a huge percent of income it is time to pass.

Returns

I repeat this over and over, but it is necessary, when analyzing each facet of a company. The amount of income a company can produce using its equity (or assets) is the best gauge for determining the validity of the company.

If management is unable to allocate its capital efficiently there is nothing else it can do correctly to make up for this and the you should pass on the company.

Also, coinciding with the last criteria I like to look at Return on Capital (income over equity plus long-term debt) and Return on Assets (income over assets) to find how much of a company's return on equity is produced using leverage: if a company is proficient at earning cash on its assets it should have no reason to borrow money, and should be internally funded.

Retained Earnings Contrasted to Market Cap

This is from Buffett's letters.

Basically, for every dollar in retained earnings (net income minus dividends) a company's market value should increase at least one dollar.

The hard thing is computing this, Quicken does it in its Buffett section, but only for company's with ten-years of stock price history.

It is true that a company needs a long history for this to be applicable, but I believe that could be five years, I'm developing a page for my spreadsheet that computes this.

That concludes the competence part, which is not very long, but management's competence should be obvious if it has a moat and good returns.

Shareholder Communication

This part is the one the I think is the least necessary. It's important for CEOs to be honest and let shareholders know what is going on.

But, I can also understand if management doesn't necessarily care about what Wall St. think so they report the bare minimum. For this reason I won't put as much weight on this part as the former two.

Earnings Reports

A lot can be found from a company's press release announcing their earnings.

First, you should look at the headline, if it is announcing the company's brilliant quarter and its strong growth be cautious, but if it just says, "X Company reports Q4 earnings," be happy.

Next, is pro forma income check into how a company determines pro forma income, if it is excluding expense that need to be included in the running of the business or adding non-cash measures ignore the pro-forma earnings and be suspicious of everything else management says.

Also, if management reports their huge growth check to which numbers they are referring. If they are using pro-forma income as their growth measure and their net income didn't grow, or fell, they are most likely dishonest.

Finally, EBITDA is a popular measuring stick. I'm all for adding in non-cash expenses, but interest and taxes must be accounted for and if you add back D&A you need to subtract capital expenditures, or this will never be accounted for.

What they say and What they do

It is a very informative exercise to read over a bunch of years of annual reports and conference call transcripts and record all of management's promises and predictions to find what actually happened.

This post was unusually long and is a lot to digest, so I'll go over Best Buy in another post.

Right Price Checklist: Moat

Business, and an explanation of the Checklist

Moat

Does it have a moat?

This may seem like one of the hardest things to find in investing, but it is inherently easy to find if a company has a moat.

A moat is just something that differentiates one's company from another and allows it to earn higher returns selling its products or services.

What is the moat?

This is harder to find, a company may have a great moat, but what is it? Do they offer the lowest price (eg Wal-Mart), are there barriers to entry in the industry (Waste Management), high switching costs (Adobe), does it have a great brand (American Express) or does it have a better quality product (Lexus).

Many companies have other variations of the above mentioned moats and many companies have multiple moats.

How long will it last?

This is the hardest thing to judge, and is usually a crapshoot.

Most technology companies rarely have a moat for long, because someone just has to come along and recreate their model.

But, some companies, like Coke, Gillette or American Express, have had moats for half a century with no signs of any one coming close to them.

Estimating how long a moat will last is the most important part of business analysis because it tells the analyst how to structure his DCF and if he's right (like many investors were with Netflix when Wall St. thought they didn't have a moat) he gains a huge edge against Wall St. and will probably earn high returns.

Best Buy

Does it have a moat?

Best Buy currently has a huge moat, as before show, it has thrashed its industry returns average over the past ten years.

In my personal experience I and a lot of friends feel Best Buy is the best place to get a gift card, and I have never seen it not completely full around Christmas.

What is the moat?

Best Buy competes indirectly with tons of stores, like Costco, Wal-Mart and Sears. But, nationally it only has two real direct competitors, Circuit City and Tweeter.

In the speciality retail industry it absolutely dominates all other competitors.

It does this through vastly superior service. Other retailers try to compete with it based only on price, but consumers still flock to Best Buy because of the service it offers.

It's Geek squad brand (which offers at home fixes for technology problems and enhance the computers by deleting useless free trial programs) and knowledgeable sales people compel consumers to go to their store instead of Circuit City or even Costco.

How long will it last?

Best Buy has been doing this for a long time, and it seems like it knows how to do it, recently renewing focus on customer service.

But, retailers traditionally can't keep competitive advantages for a very long time, Sears, K-Mart and Macy's are all retailers that once had big moats only to fall to innovation.

In a conservative estimate I believe Best Buy can keep its moat for at least 5 more years as it continues to fend off tons of companies focused on taking its customers.

I also believe that even if a brick-and-mortar competitor can break its moat (very unlikely) or a website can be established (more likely) Best Buy would still be a very attractive buy-out opportunity for a company like Amazon or Costco.

Right Price Checklist: Business

Charlie Munger has said that checklists are the best option when researching a company.

I've been using the checklist from The Warren Buffett Way to research companies, but have decided to create my own 'Right Price' checklist, that covers more information and will evolve continually as I learn and grow.

The checklist will cover: business; moat; management; financials; valuation; psychology; and the buy or sell conclusion (including two-minute drill).

Sections may be added or subtracted in the future as my philosophy evolves, but the basics will probably stay the same.

I'll go over the checklist in different posts and may ammend them as I go. To illustrate the checklist I'll use Best Buy (whom I've written about before).

Business

Translate Business Description

In the 10k businesses are required to write a description of their business, this should usually be simple and if I can't easily translate this into Real English then the business isn't that simple and should be put into the 'too-hard' pile.

Customers, Suppliers

I haven't read a lot on how to analyze these two yet, but I do know that if there are too few of them it is bad for the company. Here I will check the amount of suppliers and customers.

Risks

The company also has to write about potential risks in the 10k, I'll go over non-generic risks and what potential they have of occuring.

Products

What differnetiates this from the competiton? Is it a repeat purchase product? If the company sells a product that needs to be purchased over and over again (like a razor) it's easy to create revenues, but if consumers only purchase the products every few years (like a car) then they may have trouble staying consistent.

Consistency

Because of my love for turnarounds this one will be loosely judged, I will want to have a few companies in my portfolio that have very consistent histories and easily predictable future earnings. But, I will also want to own a few companies that do not have a consistent history or no history at all and will probably turn-around.

High Returns

Finally, if the business has a repeat purchase product, a consistent history, hundreds of suppliers and customers, no real risks, but low returns on capital there is no reason to invest in it. I will look at returns on capital and margins.

Best Buy

Translate Business Description

Best Buy has a business description that Mohnish Pabrai would like: it's only two paragraphs. My translation:

Best Buy is a speciatlity consumer electronic retailer. It does this through its brands: Best Buy; Five Star; Future Shop; Geek Squad; Magnolia Audio Video and Pacific Sales Kitchen and Bath Centers.
Best Buy attempts to make life fun and easy for consumers. They believe they offer customer advantages in store environment, product value, product selection, and a variety of other servcies related to product purchasing.

Customers, Suppliers

This one is easy for Best-Buy it has millions of customers (literally), and most likely will never have to worry about anyone of them accounting too high a percentage of sales.

The suppliers are less diversified with the top 20 vendors accounting for >60% of their products. This includes huge companies that will likely not go under or stop selling at Best Buy soon, so this does not worry me.

Risks

Of the risks mentioned only two come across as being big enough to stop me from investing.

First, the competitive pressures from traditional retailers and the Internet. Best Buy absolutely blows all the other brick-and-mortar competitors out of the water, but I am very worried about the potential for a tech-focused, or even Amazon, website to come along and compress Best Buy's margins and returns.

Second, and less risk, Best Buy's earnings are very dependent on the fourth quarter (Christmas). This is true with most retailers, but if they screw up one or two ads in October it could mean a huge hit to total earnings.

Products

Best Buy is a tech retailer. It's products, like computers, DVD players, TVs, etc. are not repeat purchase products, but I do believe that customers who buy a TV from Best Buy and are satisfied with the service are very likely to come back and buy the DVD player for the TV and a few DVDs from Best Buy.

Also, Tech is traditionally a high growth industry and I believe Best Buy is shielded from the volatility of more focused tech companies because it doesn't suffer from bad products releases because consumers would just buy a different computer (or other product) which Best Buy also sells.

Consistency

Best Buy has done pretty well over the past ten years, and pretty consistent, it did not post negative growth year-over-year.

Returns

Over the past 10 years Best Buy's returns have routinely thrashed the industry average.

That concludes the business section of the check list.

I'm pretty sure I left some stuff out so if you have any things you feel should be added please comment with your suggestion.

Updated About Section

I've updated the About the blog post.

The post goes over my investing history and the history of the blog, and requests for more info can be added.

You can find the link here: http://mikesnewsletterinvesting.blogspot.com/2006/06/about.html

Multiple Disciplines

In futhering my mental models in the spirit of Charlie Munger I've been reading pretty much non-stop on economics over the past month or two.

Last night I started a new book, Discover Your Inner Economistby blogger Tyler Cowen.

In the first chapter of the book Cowen talks about how to distinguish good economics from bad:

1. The Postcard Test: In this test he recommends never buying a theory where it cannot be explained on the back of a postcard. Theories which are too complex and need to be explained on a 46-page paper then it probably has too many uncertain steps
2. The Grandma Test: Before teling anyone your economic theory make sure it is intelligible enough to explain to your grandmother
3. The Aha Test: If the theory is explained well it should make sense and the listener should experience an 'aha' moment of comprehension.

One could do well translating these rules to investing. They do not sound very far off from superinvestors such as Peter Lynch and Mohnish Pabrai who have rules of a two-minute drill which means one must be able to explain the thesis in two minutes and a rule of being able to explain the business in a paragraph respectively.